Tax Benefits in Multi-Family Real Estate Development Lower Effective Tax Rates

The average duration of investments in the table was a total holding period of 45 months with an average multiple of 2.6x. While we do not expect all projects to generate average net returns of 30%, even those very high performing projects in the above table have effective tax rates that are much lower than other types of growth investments. Driving this low effective tax rate are passive losses in early years that can be netted against passive income and gains in other parts of investors’ portfolios, and the fact that most of the gains on a sold project come in the form of long-term capital gains.

In comparison, growth-oriented investments like equity mutual funds, and even actively managed equity ETFs, tend to have much higher effective tax rates. That’s because even if an investor buys and holds one of these investments for many years, the funds themselves tend to have significant turnover. Average turnover rates for the largest equity mutual funds are estimated at 60% or more. Even when including a mix of passive equity funds, average turnover rates are estimated to be higher than 30% annually. That means both long-term gains (taxed at 20%) and short-term gains (taxed as regular income as high as 37%) are being realized each year; and those funds are generating dividend income (also typically taxed at 20% or more).

While every person’s tax circumstances are different, our initial example above could be very close to reality. Comparing investments in taxable accounts on an after-tax basis is critical. A before-tax return from a public market portfolio is very unlikely to have similar after tax returns as a tax-efficient real estate investment. We suggest you consult with a tax advisor when considering tax issues related to your investments, and highly recommend comparing potential investments on an after-tax basis.

*Note: The key assumptions in our analysis of effective tax rates assumes investors are in the top tax bracket and achieve maximum tax savings from netting losses and from marginal differences in income vs capital gains tax rates. We do not account for state taxes which can impact these results further.